The Tax Byte

Planning for the Tax-Free
Sale of Your Home

Create Wealth With a Seller Takeback When You Sell Property

The seller takeback is the first or second mortgage payable by the buyer to the seller. In its first or second position, the seller secures the mortgage with the property. Since the seller knows the property well, he or she knows the value of the collateral. This backdrop sets the stage for rock-solid profits.

Build bigger profits: With the seller takeback, you have several ways to increase your profits, including:

Charging a rate of interest greater than you can earn from the bank or on your money market
Charging a rate of interest equal to the mortgage rate
Charging more for the property because you are willing to take paper

Example 1: The bank is at 2.7 percent. Money markets are at 3 percent. Ten-year Treasury Bills are at 6 percent. You can earn 9 percent with second mortgages. Assuming you invest $50,000 at these interest rates, your cash accumulation after 10 years is:

$65,264 in the bank
$67,196 in the money market
$89,543 with Treasury Bills
$118,368 with second mortgages

To put the numbers in perspective, think of this: You add $65,000 (almost double) to your bank account by taking the second mortgage on sale of your property. Where else can you find a safer and surer investment?

Example 2: With no seller financing, you can sell the property for $140,000. With seller financing of $50,000, you can demand a premium and get a selling price of $145,000.

In other words, you earn $5,000 for thinking of it and another $65,000 or so for doing it. The $5,000 up front adds tremendously to your rate of profit.

Increase the chances of sale: When you take a second mortgage on the property, you make it possible for more prospects to buy your property. The in-place second mortgage often makes it easier for many buyers to qualify for a first mortgage.

Collect cash before paying the taxes: With a seller takeback, you collect the cash and then you pay the tax. Tax law taxes the profits as the cash gets collected. No cash, no tax. Little cash, little tax, etc.

Charge points to increase Investment return: When you take the second mortgage, you allow the buyer to keep more cash - certainly enough for you to charge a point or two on the takeback. Moreover, the second mortgage is a financial instrument. You should treat it as such and demand points, just like the commercial lender. With the points, your investment return grows dramatically.

Example: You collect 2 points and take a 30-year, $30,000 second mortgage at 8 percent interest. First, the 2 points increase the 30-year effective interest rate from 8 percent to 8.44 percent. Second, when the buyer pays off the mortgage early, say in five or seven years, your effective interest rate rises dramatically - to 17 or 19 percent in many cases.

Planning note: Most buyers do not keep the property for 30 years. In fact, historical averages show that most buyers keep property for less than 8 years.

Lower your tax bite: The IRS collects taxes in brackets. You can use the seller takeback to spread taxable income over more tax years and keep yourself in lower tax brackets. Structure the deal to multiply your profits if the buyer defaults: When you take that second mortgage, you have to think: "What will happen if the buyer does not pay? What does the tax law do to me if I get the property back?"

Repossession profit: Repossessing property sold by the installment method does not destroy the benefits. Your repossession tax profit is based on the lesser of:

The untaxed portion of previous installments, or
Total gain minus reacquisition expenses and previously reported gain.

Any remaining gain remains untaxed until you resell the property - and further deferral is possible, if you resell using the installment method.

Example: Assume you sold property in which you had a basis of $40,000 for $200,000. You received a $20,000 down payment and a 9 percent note for $180,000 payable in $20,000 installments for 9 years. Your total profit on the sale was $160,000 ($200,000 contract price less $40,000 basis). Your gross profit percentage on the sale was 80 percent ($160,000 divided by $200,000 contract price). The buyer pays you $60,000, then defaults. You repossess the property. You figure your gain on repossession as follows:

Payments received to date	$60,000
Taxed before (80 percent x $60,000)	(48,000)
Repossession gain	$12,000

You pay tax on the $12,000. It represents cash collected on your old basis. Since you now have the property back and therefore no basis of sale, the government wants to tax money on all cash collected.

New Basis: After repossession, your basis in the property is the same as when you sold it, plus reacquisition costs.

New Basis Example: Your original basis in the property was $40,000. After recognizing the gain on repossession, your basis is still $40,000. If it costs you $1,000 to repossess the property, you add the $1,000 to the basis of your property for a new basis of $41,000.

Repossession of home - special one-year resale rule: You save all or part of your tax-deferred rollover by reselling your former principal home within one year of repossession. The basic idea: You combine both the original sale and the repossession sale and treat them as one sale. Then compare the net sales proceeds from the double sale with the cost of your new home. If you do not resell your home within a year, you lose the tax-deferred rollover.

Make relatives wait 2 years before sale: If you sell depreciable property on installment contract to your:

Brother
Sister
Spouse
Parent
Grandparent
Child
Grandchild

and that relative sells the property within 2 years after acquiring it from you, you must report as taxable income all deferred gain on sale.

Example: Dad sells a rental property to his son under and installment contract (he takes a first mortgage). Dad's profit is $100,000. He will report taxable income of $5,000 for each of the next 20 years as he collects annual payments of $9,000. But the Son pulls the big NO NO! In the 14th month, the Son sells the property to Nelson, not a relative. Here is what happens to Dad:

He collects $9,000 cash from his Son
He pays tax on $95,000 (the remaining unrecognized profit)

Other related parties: The "wait 2 years before resale rule" also applies to sales by you to:

Corporations in which you and your relatives directly or indirectly have 50 percent or more ownership
An S corporation in which you own stock
Partnerships in which you have an interest
Trusts that name you as a beneficiary
Grantor trusts that treat you as the owner

Planning tip - sell to non-relatives: Under the installment sales rules, your relatives do not include your:

Uncles
Aunts
Nephews
Cousins
In-laws

Lower the interest rate, raise the price, and cut your taxes: Assume you sell the property for $150,000 and the buyer will pay $30,000 down and give you a 10 percent $120,000 fixed-rate 30 year mortgage. On this mortgage, monthly payments are $1,053.09. If you keep the $1,053.09 payment and lower the interest rate to 7 percent over the 30-year mortgage, the principal increases to $158,286.78. If you make this change, you convert the $38,286.78 increase in principal from interest income to tax-favored capital gain. You do this with no change in your cash flow from the transaction. You get $1,053.09 a month either way, but with the lower interest rate you cut your income taxes.

Minimum interest rule: On an installment sale under $2.8 million, you must charge interest at a rate no less than the lower of:

9 percent, or
The applicable Federal rate

The Federal rate changes monthly. The current month's rate for mortgages and loans longer than 9 years is 6.80 percent.

The escrow account: You may qualify for favorable installment sale reporting when the buyer puts cash in an escrow account, provided the escrow meets three conditions:

The escrow agreement is part of an arm's length installment sale contract between you and the buyer
You receive no present benefit from the escrow funds (such as monthly interest)
The escrow agent is not your exclusive agent

Avoid seller takeback if excess mortgages kills benefits: Save tax dollars! Do not let the buyer assume your mortgage if your mortgage balance is greater than your adjusted basis in the property.

Reason: You must count the excess as a taxable contract payment in the year of sale.

Example: You sell a duplex for $150,000. The buyer pays $20,000 down and assumes your existing mortgage of $130,000. Your basis in the property at the time of sale is $40,000. The $90,000 excess basis ($130,000 - $40,000) counts as a payment in the year of sale and the entire $110,000 profit ($150,000 - $40,000) is taxable in the year of sale.

Planning tip: You can avoid the excess mortgage trap with a wraparound mortgage. In this arrangement, you sell the property subject to a new second mortgage that wraps around the first mortgage. The buyer makes wraparound mortgages payment to you. You continue to make payments on your original mortgage.

Avoid loss of capital gains - do not sell to 80 percent or more owned entities: If you sell depreciable property on the installment basis to your 80 percent or more owned entity, all gain on sale is (1) recognized immediately as (2) ordinary income. You lose your capital gains!

Avoid the recapture disaster: An installment sale of property that involves depreciation recapture is a disaster. It requires that you report all depreciation recapture as ordinary income - entirely taxable in the year of sale - regardless of cash collected.

Example: You sell a commercial building that you purchased in 1982. Depreciation recapture is $120,000. The $120,000 is taxable in the year of sale - even if you collect no cash.

Ensure realization of passive losses at time of sale: The installment sale (owner takeback) robs you of your suspended passive losses. When you completely dispose of a property (e.g., sell it), you deduct all your suspended passive losses on that property. In an installment sale, you may deduct suspended passive losses only to the extent you collect the profits.

Example: You collect 30 percent of the profits. You may deduct 30 perfect of the suspended losses.

Planning tip: If you want the losses now, do not take back a mortgage.

Summary: Seller financing can be a great way to create wealth from your existing situation. You know your property. With the seller takeback, you know your rate of return at the time you enter the transaction. Your downside risk is minor. If you find yourself in a position to use the seller takeback strategy, read this article several times. Make sure you consider the ways to ensure and enhance your rate of return.